| Illustration by Bruno Budrovic/Illustration Source |
Many hospitals and health care systems may not be aware that they are sitting on a treasure chest of slumbering capital that is waiting to be roused and unleashed — the equity within their owned real estate.
Just as hotel and retail business owners learned a few decades ago, hospitals and health care systems are reconsidering the strategic value of their owned real estate and asking if it’s time to monetize their assets to redeploy that equity as capital to fund new acquisitions, medical equipment and future growth initiatives.
• Health care organizations have begun acting more like retailers with regard to their outpatient operations.
• This restructuring has given organizations the opportunity to access needed capital through their real estate assets.
• Organizations must ask themselves three key questions to determine whether such a course will be advantageous.
Monetizing real estate assets historically has been viewed by hospitals and health care systems as a strategy of last resort due to concerns about control over the uses of the facilities, jeopardizing the hospital-physician relationship, and the ability of new owners to maintain the same standards of care for the facilities as the hospital.
Health care real estate is poised to benefit from favorable demographics driven by the aging baby boomer population’s demand for health care services. Investors have taken note and dramatically increased their allocations to this sector in 2015, and even more funds for health care real estate are projected to be available in 2016.
Three key questions
Despite the many financial challenges facing health care providers today, one bright spot has been the value of health care real estate, which has increased significantly because of low interest rates and the rising demand from institutional capital sources.
Concerns about monetization have tempered as many health care organizations reinvent their outpatient strategies. Less focus on developing master campus environments and more focus on expansion into new markets represents a paradigm shift among health systems striving to offer greater convenience for their patients while capturing greater market share.
As health care providers start thinking more like retailers with regard to their outpatient strategy — analyzing demographic, psychographic, traffic, business and industry data — the question becomes whether it also makes sense to approach real estate the same way as traditional retailers, such as Walgreens, Starbucks or Subway, who primarily lease their facilities.
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There are no hard and fast rules. But, by answering three key questions, a health system can put together a real estate strategy that is relevant for any business.
What does the health care organization own? While this question is somewhat simplistic, it is one for which many health care systems have difficulty providing a comprehensive answer. The question goes far beyond knowing the physical addresses of each asset, but having actual knowledge of the age of each facility, Building Owners and Managers Association (BOMA) standard square footage measurements, detailed operating expense data, aggregation of lease agreement documentation and an understanding of the condition of the facility operating systems.
Not only are these questions relevant for any investor who would want to purchase a health system’s real estate assets, the answers oftentimes can provide opportunities for additional income and minimize risk for a hospital. For example, a building that has not been measured to BOMA standards may not be calculating rentable square footages according to industry standards. While the usable square footage is the actual space a tenant uses, the rentable square footage incorporates the tenant’s proportionate share of common areas in the building. If a hospital is leasing space to third-party physicians and the space is not measured correctly, the hospital could be missing out on additional income and, more importantly, may be under a Stark Law regulatory risk.
Another example would be analyzing the operating expense of each facility. If a health system decides to monetize its assets at some point in the future and has not benchmarked its buildings' operating expenses, it has likely left money on the table for an investor purchasing the facilities. To price a facility, an investor will analyze potential income from tenants against the building’s expenses. The more accurate the operating expense tracking, the higher the probability that pricing can be pushed higher because there is less ambiguity about the kind of expenses to which the investor may be exposed in the future. However, expenses typically are underwritten based on historical performance, not where a building should be performing.
Finally, understanding a building’s infrastructure systems is paramount for the services being provided in the building and for establishing a future capital budget. The four big-ticket items are elevators; heating, ventilating and air conditioning; roofing; and parking. Understanding where a hospital has future capital exposure can help with the monetization decision and whether the health system should make these capital investments or leave the responsibility to a new owner.
Why does the health care organization own it? The reason for ownership is both an economical and philosophical question. Economically, it may make sense for a hospital to monetize the assets in question, because the opportunity cost to place the capital in a new outpatient venture may outweigh the benefit of owning the bricks and mortar. On the other hand, a hospital may have received a significant donation and named the building after the donor. Philosophically, for that particular hospital, it may not make sense to monetize the facility in question.
While medical and administrative facilities receive the most attention in determining why a hospital owns its real estate, there are other assets that typically get overlooked.
For example, parking structures and data centers are often ignored in this exercise. Several years ago, a Northeastern hospital faced a parking challenge with its urban campus. This particular campus receives more than 1 million visitors per year and valets more than 90,000 cars per year due to insufficient parking supply under control of the hospital. With an ambitious campus development underway that included a 225,000-square-foot academic research center and a 250,000-square-foot ambulatory care facility, the hospital decided to monetize the parking component of its campus through a joint venture with a parking facility owner, development and management company. The joint venture included the real estate, as well as an operating and option agreement that set pricing guidelines and established operating standards, allowing the hospital to allocate its scarce financial resources to other clinical services.
Patient data are also a critical component to any hospital and many health systems believe the electronic data should be housed in a facility owned by the hospital. Outsourcing to cloud vendors could seem like a risk to health care chief information officers, but it also could allow a hospital to transfer risk to an outside party that is held to the same HIPAA standards through the Omnibus Rule. A few years ago, the Northeastern hospital also decided to outsource its data center, which served both a university and the medical center, after an outside engineering firm discovered the data center was underpowered, provided inadequate cooling and was an inefficient use of space. The facility ranked Tier I out of IV on the Uptime Institute metric of data center reliability. Instead of rebuilding the data center, the hospital moved its data 30 miles away to a facility owned and managed by a provider of data center services, hosting and disaster recovery. The move saved the hospital money, provided more reliability and freed up real estate on its urban campus.
What is it worth? This question can only be answered after a health care organization has determined what it owns and has compiled reliable data on the actual performance of the real estate to be valued. Too often, health systems get appraisals or an opinion of fair market value (FMV) to determine the value of their real estate, but have insufficient data for an appraisal firm to come to an accurate valuation. Instead, the appraiser will use market assumptions, which may not reflect the actual performance of the facility in question or the actual market conditions for health care assets, leading to a valuation that could deviate significantly from how an investor would underwrite the real estate. For example, many appraisals and FMV analyses for health system real estate use the average from a recent operating expense survey for similar buildings in the same market. This can create an inaccurate estimate of value by tens of millions of dollars when actual operating data are reconciled with the assumptions made in the appraiser’s analysis.
Determining the value of a health system’s real estate is an exercise that is relevant for any business, and it should be done frequently. An appraisal typically establishes value based on sales comparison, income and cost. The sales comparison approach to value bases its opinion on what similar properties have sold for recently, sometimes going back several years. The cost approach seeks to determine how much a property would cost to replace by summing the value of the land and reproduction costs of the improvements and then subtracting accrued depreciation, and the income approach analyzes a return an investor could achieve in owning the real estate.
While appraisals are great tools to determine book value, it is important to understand that an appraisal does not reflect what a health care real estate investment trust or pension fund may pay for the property. An appraisal analyzes historical data while an investor evaluates current market conditions in their approaches to value. As such, a detailed broker opinion of value based on current capital markets data compiled by a professional real estate organization is a wise supplement to any appraisal.
Sources of capital
Many hospitals and health care systems continue to seek new sources of capital to fund their need to grow and evolve in the face of competitive market forces and the demands of the Affordable Care Act, and most health care providers already own substantial assets in real estate. The majority of these owned real estate assets are not mission-critical, have substantial equity value and could be utilized better to unlock the capital needed to fund growth initiatives.
As health care systems evolve and realize they no longer need to own all of their real estate assets, they should ask themselves the right questions.
Christopher R. Bodnar and Lee Asher are executive vice presidents and co-leaders of the U.S. Healthcare Capital Markets Practice at Los Angeles-based CBRE Inc. They can be reached at firstname.lastname@example.org and email@example.com.
Capital gains through property monetization
A nonprofit health care system had five medical office buildings on their hospital campuses, with an average age of 27 years and more than $2 million in deferred maintenance. Of the existing tenants, 67 percent of the leases were scheduled to expire in the following five years. One of the hospital campuses was performing poorly financially and the health system needed to raise capital to fund its growth initiatives. If the system were to sell the buildings, it was concerned about the possible loss of control over the future of these important on-campus assets.
Los Angeles-based CBRE conducted a thorough analysis of the buildings and determined the value of each asset with new lease terms for the health system's occupied spaces. The firm created a detailed investment offering package, and openly marketed the portfolio to third-party real estate investors. In addition, the real estate firm advised the health system how to structure the ground leases on each asset with non-compete language to protect the assets from being leased to a competitor, thus allaying the health system’s concern about future control of the assets.
Through the firm’s competitive process and industry contacts, the investment offering received nine qualified offers for the portfolio. After subsequent rounds of bidding, the winning bidder increased its final offer by $3.5 million over its initial offer, achieving 100.38 percent of the target pricing goal.
The health system was able to retain the control it required for these assets while receiving a significant cash infusion from the sale proceeds that it could use for expansion and operations initiatives. In addition, the new third-party owner of the buildings pledged a large amount of capital to improve the infrastructure of the buildings, address deferred maintenance issues and add aesthetic enhancements with new high-end finishes to the common areas, which would help to retain existing tenants and attract new ones to the buildings.
KEY QUESTION #1
What does the health care organization own?
Many health care systems have difficulty answering this simple question which includes the age, square footage measurements, operating expenses, lease agreements and condition of facility operating systems.
Don’t overlook …
Measuring rentable square footage, including tenants’ proportional share of common areas
Benchmarking building expenses to minimize potential ambiguity that factors into price
Analyzing future capital exposure from big-ticket items, including elevators, HVAC, roofing and parking
KEY QUESTION #2
Why does the health care organization own it?
Health care systems have both economical (cost/benefit) and philosophical (holding on to a building named after a donor) reasons for decisions regarding their real estate portfolios.
Don’t overlook …
Finding ways to monetize facilities that are used for nonclinical services, such as parking garages and data centers
KEY QUESTION #3
What is it worth?
This question can only be answered after a health care organization has determined what it owns and has compiled reliable data on the actual performance of the real estate to be valued.
Don’t overlook …
Gathering as much data on actual market conditions as possible so that an appraiser will not have to rely on market assumptions
Securing a detailed broker opinion of value based on current capital markets data compiled by a real estate professional